Managing Commodity Price Volatility

Transcription

1 Business and Technology Insights Managing Commodity Price Volatility Inside: Ex ecutive Summar y Background Assessment Gu idance Summary

2 Dynamic Managing Commodity Price Volatility Executive Summary As the boundaries of our national economies have all but dissolved into the Global Economy; commodity price volatility becomes increasingly diffi cult to manage. New technologies, growing economies, and a world shift in living standards are causing prices to be more volatile than ever. This uncontrolled fl ux in pricing has a major impact on your company s fi nancial livelihood, especially those with low margins and high material costs. In their attempts to survive, companies are compensating through old and suboptimal techniques such as surcharges, long term price locks, and stockpiling. Instead, companies need to rethink their current technology DNA and look up to the cloud to create a solution that delivers a whole new way of doing business. Background The economies of the world are now highly interconnected. The world is no longer comprised of collections of highly localized economies each with their own protectionist practices. Businesses have become global, the world has fl attened and economies are all dependent upon one another. The chief consequence of this is that spikes or falls in demand in faraway parts of the world can trigger extraordinary implications all over the planet. These spikes or falls create new problems for manufacturers, shippers, consumers, intermediaries, salespeople, traders and more. Businesses that were built with solid, albeit hard to change, processes, systems and work practices will have an exceptionally diffi cult time in a more dynamic business climate. Price volatility is an area of great concern to us and our clients. Signifi cant swings have occurred in recent years in fuel, metals and other commodities. Events like the economic collapse of 2008 have dramatically reduced a number of prices in the construction industry (and other YOUR ORGANIZATION Static Static BUSINESS YEARS AGO YOUR BUSINESS ENVIRONMENT THE DYNAMIC ENTERPRISE industries) as capital access has become more diffi cult. Fuel prices have wreaked havoc with major airlines, transportation companies and automobile owners. Dynamic page 1

3 Price volatility in some sectors, for example metals, is particularly acute. The BRIC countries (i.e., Brazil, Russia, India and China) are experiencing signifi cant internal economic growth often at rates more than two times that of GDP growth within the United States. The demand in those countries for structural steel and rebar is tremendous as these nations continue to build out their infrastructure. Steel, aluminum, copper and other metals are in great demand in these countries for use in automobile production, capital equipment production and commercial building. For example, global automobile ownership was approximately 800 million cars in the world, yet by 2030, that count is expected to exceed 2 billion, with China and India poised to grow faster than anyone (Dargay & Gately, 2007). Plastics and petroleum feedstocks are needed to meet the growing demand for product packaging, electronic goods and other products that are being desired by a growing, more affl uent population within these and other nations. The growing global demand for alternative energy solutions, fuel cells and batteries is triggering increased demand for rare earth and precious metals. (Brown, 2010) Car ownership rates projections (EEA, 2010) Price volatility is a business reality that must be consciously and aggressively addressed by dynamic businesses today. Businesses that continue to ignore this do so at their own peril. At Baker Tilly, we believe this will not only continue to exist, but the magnitude of the swings and their frequencies will continue and amplify in intensity over the foreseeable future. We believe that price volatility: > Makes every business more vulnerable than ever before > Cannot be ignored > Must be actively managed > Can be exploited for competitive advantage > Will continue for many years as large portions of the world continue to build their economies and create stronger middle class segments of their population Data from page 2

4 Assessment Price volatility can have a major impact on your company s fi nancial livelihood. For businesses in industries with low margins and high materials cost, price volatility is especially troublesome and can make for some very interesting and, sadly, devastating fi nancial results. In these industries, the difference between fi nancial success and outright bankruptcy may be razor thin. Price volatility often sorts out which companies are better able to manage during volatile times. Based on our experience with metals manufacturing companies across the United States, materials make up roughly 70% of Costs of Goods Sold, or approximately 50% of Net Revenue (70% x 75% = 52.5%). Even a small fl ux of 3% in raw material prices (e.g., steel) is equivalent to 88% of their net income. While this outcome differs from industry to industry, the ratio s magnitude cannot be ignored. Sobering Math Profit Impact for Metals Firm Net Income by Manufacturing Industry Traditional P&L Values Impact of 3% increase in Raw Material Cost Industry COGS Net Income Total Revenue COGS Materials Labor/Overhead Other Costs $1,000,000 -$525,000 -$225,000 -$232,000 $1,000,000 -$540,750 -$225,000 -$232,000 Automobile Parts Automobile Primary Metals Architectural and Structural Metals Fabricated Metal Product Metal Coating/Engraving/Heat Treating 71% 77% 81% 74% 72% 76% 0.2% 0.2% 2.1% 2.4% 2.7% 2.9% Net Income $18,000 $2,250 Average 75% 1.8% Data based on research from First Research. Industry based on NAICS code. Net income is average of all US companies in the industry with no discrimination based on size/revenue. Different industries have varying abilities to absorb price changes. Hard industries, like manufacturing, are particularly exposed to price volatility. Traditional Methods of Dealing with Price Volatility To manage volatility, companies have been compensating with several, often suboptimal, techniques. One of the more common techniques is via price adjustments and surcharges. Managing a surcharge program is a messy process, often requiring the addition of personnel solely to administer these initiatives. Part of the reason for this is that few companies handle surcharges the same way. Some add these costs as spot adjustments to the quoted price. Other companies create a separate cost line item while others calculate a consolidated month end fee. These methods, their timing and materiality virtually guarantee that your organization is spending a material amount of time resolving billing discrepancies. Another commonly used method is to employ long term price locks. This technique is becoming less and less viable in an increasingly more volatile, dynamic business climate. As such, it may be a lose/lose strategy nowadays. Why? When prices rise you cannot raise prices, even though the replacement cost for raw materials may have moved up markedly and unprofi tably. The customer clearly wins in that scenario. In the case when prices fall, customers may withhold orders and place them instead with suppliers offering lower-cost products. Alternatively customers may only agree to continue buying from your company if you agree to reduce your costs to match those of competitors. Either way, your company loses. page 3

5 Stockpile strategies can theoretically provide safety, but they also present massive risks. Stockpiling requires more capital than most companies have available if it is to have a material impact. Stockpiling is different from small buys you make when you have great certainty of booking near-term orders. Stockpiling is speculative buying. It is a hedge on your raw materials in expectation of climbing raw materials costs. The problem with stockpiling is risk, and the commodity market, like the stock market, is a risky proposition. Gambling on materials is gambling with the fi nancial stability of your company. Even for the few companies who are well in tune with the market, your capital may be better served on growing your business. Remember, yours is not a commodities trading company. Source: kitco.com Guidance Overall, businesses must have more dynamic pricing, ordering and accounting systems to better align raw material costs with customer orders. Competition, the marketplace and customers would expect nothing less in this more volatile economic setting. Furthermore, the faster companies can develop these more sophisticated pricing and risk management systems, the greater the fi nancial stability they can bring to their own companies. A new dialogue between buyers and sellers is needed in the marketplace today. The concept of a catalog with fi xed prices may become a quaint artifact of past business practices. Smart companies can clearly identify the components of cost of goods sold that are within their control as well as those beyond their direct control. Pricing, therefore, must contain two components (static and dynamic cost components) today and companies must become comfortable with explaining these two cost buckets with customers. For example, your company may need to include multiple line items for different cost categories for every item you sell (e.g., labor, materials, transportation). Sellers must provide transparency to buyers regarding these costs and the factors that will be used to adjust prices up or down. While this approach has similarities to the surcharge method, it differs in that it: > Requires cost accounting systems to possess signifi cant levels of increased market intelligence > Requires greater communication between buyer and seller at a more granular level of order taking > Transfers some of the raw material inventory cost risk to the buyer > Provides a more defensible and auditable pricing schema > Requires changes to a company s ordering tree and/or catalog systems So, how do you design a system to manage price volatility? The way you currently are managing raw material prices is probably dictated by the limitations of your ERP software. Older ERP systems were built around traditional business models, processes, etc. These traditions have roots in an older industrial age timeframe when commodity prices did not move with the speed and volatility experienced today. Additionally, these software solutions may have been designed without any concept of applying surcharges due to rapidly changing materials costs. Your company s ability to manage price volatility may be directly related to the vintage of your ERP software. You may have some diffi cult choices to make as to whether you need to replace and/or modify your core business software. page 4

6 When it comes to designing/enhancing your business solution, don t just think how the system works, rethink the processes to support your business needs. > Focus on right term contracts, not long-term contracts. If your material prices change every quarter, then so should your prices. > Build flexibility into sales, ordering, hedging and other processes to accommodate future volatility. If your current suppliers adjust fuel costs on a quarterly basis today, be prepared to handle much shorter timeframe adjustments in the near future (e.g., daily or hourly). > Test new processes for extraordinary events. Great manufacturing and supply-chain processes do more than accommodate the usual business situations with usual prices. Great manufacturing and supply-chain processes work well during acute situations. For example, if a major natural disaster were to disrupt a signifi cant number of suppliers to your industry, how would your orders, pricing and more be affected? Would your processes and systems be able to make appropriate adjustments without adversely impacting your company s bottom line? > Be proactive with upfront pricing updates, instead of post sale surcharges and adjustments. You need to completely rethink how you price your products, while keeping it simple. > Develop a solution that goes beyond the original issue to provide additional value to your customers. When you rethink the process, you get to re-establish the benefi ts. Look outside of your environment to deliver a whole new level of service to your customers. In addition to your products, you could deliver timely established pricing and lock in stable relationships one period at a time. Your customers will quickly appreciate the peace of mind of a worry free supply chain. > Evolve your technology DNA, and leave the spreadsheets behind. The ability to command > Creating a Competitive Advantage with Cloud Technology > A metal fabricator company that produces medium to heavy-gauge components needed to fi x a complicated process to manage customer pricing due to price volatility in the metal commodities market. > > Baker Tilly helped the client rethink the way they priced their products by leveraging cloud computing to develop an entirely new approach to pricing. They leveraged a cloud based solution to integrate metal price index information into the system to drive calculations using live ERP data to deliver an instant and centralized management tool. > > The new cloud based solution provided a higher level of speed and accuracy than their previous on-premise technology and streamlined processes. This helped simplify transactions throughout the value chain through faster, more accurate price rollouts, secured data points, and reduced overall workload on their account managers. The new solution also included an array of error proofi ng options such as missing prices, incorrect part weights, and negative values. > > As a result, the company created a major selling point to new and existing customers over its competitors by simplifying business processes and transactions through cloud based technologies to address market volatility. Define Commodity Indexes and Price Calculations Assign Price, Dates, Commodity Index and Calculation Method to each customer part Assign amount of material used on the engineering master Run the Price Preview Mode to provide new prices to your customers Turn off Preview Mode and update new prices in the system information is quickly becoming manufacturing software s greatest asset, and the cloud is winning the race. > Develop technical awareness beyond the transactions. Your sales team in the fi eld needs to know just as much about how your new solutions technically function what it can offer your customers. Your solution is not just a piece of technology behind the scenes, it is also your customer s solution to better business, and that also needs to be sold. > Understand your ability to leverage your technology. Changes to ERP in the cloud are fast. When your customers need something from your system that doesn t exist, you have the opportunity to deliver more than just your products, but also the future of business processes. Knowing your abilities and limitations can fast track a sales call to a sales contract. page 5

7 Summary Through our years working with cloud ERP, we have found that the best solutions are a delicate blend of technology, process, and the people who use them. Once you have a solid understanding of your processes and the right people on board, then you are ready to advance your technology. Fortunately the cloud is offering fast, tailored solutions to meet many of the challenges of modern business. If you are facing an opportunity like this, then it is time to start talking with your customers about how you can work together to create the next wave of mutually benefi cial solutions. Then come talk with us. Bibliography > Brown, e. a. (2010). Solar Panel Redesign to Recapture Materials Costs. Madison: University of Wisconsin - Madison. > Dargay, J., & Gately, D. S. (2007). Vehicle Ownership and Income Growth, Worldwide: Leeds: University of Leeds. > EEA. (2010, 12 13). Car ownership rates projections. Retrieved 1 6, 2012, from European Environmental Agency: eea.europa.eu/data-and-maps/figures/car-ownership-rates-projections > Hoover s, Inc. (2011). Fabricated Metal Product Manufacturing. First Research. > Liebman, B. (2006). Safeguards, China, and the Price of Steel. Philadelphia: Saint Joseph s University. > Suga, S. (2010, 10 15). Steel Output Cut in China Spurs Prices, Has `Big Impact, Tokyo Steel Says. Retrieved 1 5, 2012, from Bloomberg.com: page 6

8 Contributors Matt Haller Principal Peter J. Pearce Principal Kyle Brown Consultant About Baker Tilly Baker Tilly is a full-service accounting and advisory firm whose specialized professionals connect with you and your business through refreshing candor and clear industry insight to provide high value results. Our specialized expertise and global reach in audit, tax, and management consulting support your organization s goals with knowledgeable, competitive insights. As an independent member of Baker Tilly International, the world s eighth largest network of accounting fi rms, we bring you access to market-specifi c knowledge in 120 countries. We believe that exceptional client service comes down to a single idea...trust. The trust that comes from working with people dedicated to understanding your business needs. People who respond to the challenges you face today and anticipate the opportunities of tomorrow. Our clients recognize the differences that set us apart. > Proactive, personal, and responsive client service > Informed observations and recommendations from experienced professionals who know your industry > Active in a strong global business network > Team approach that ensures continuity and access to partners and managers > Broad industry and service offerings with deep specialization We bring our skills, integrity, and energy to each client engagement. Connect with us: connecting@ page 7 Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. The information provided here is of a general nature and is not intended to address the specifi c circumstances of any individual or entity. In specifi c circumstances, the services of a professional should be sought Baker Tilly Virchow Krause, LLP